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An Internal Model-Based Approach to Market Risk Capital Requirements

V. Stress testing

1. Banks that use the internal models approach for meeting market risk capital requirements must have in place a rigorous and comprehensive stress testing program. Stress testing to identify events or influences that could greatly impact banks are a key component of a bank's assessment of its capital position.

2. Understanding and protecting against the vulnerabilities of a financial company's risk-taking activities is of course one of the major responsibilities of its board of directors and senior management. Banks' stress scenarios need to cover a range of factors that can create extraordinary losses or gains in trading portfolios, or make the control of risk in those portfolios very difficult. These factors include low-probability events in all major types of risks, including the various components of market, credit, and operational risks. Stress scenarios need to shed light on the impact of such events on positions that display both linear and non-linear price characteristics (i.e. options and instruments that have options-like characteristics).

3. Banks' stress tests should be both of a quantitative and qualitative nature. Quantitative criteria should identify plausible stress scenarios to which banks could be exposed. Qualitative criteria should emphasise that two major goals of stress testing are to evaluate the capacity of the bank's capital to absorb potential large losses and to identify steps the bank can take to reduce its risk and conserve capital. This assessment is integral to setting and evaluating the bank's management strategy and the results of stress testing should be routinely communicated to senior management and, periodically, to the bank's board of directors.

4. The Committee recognises the difficulty associated with identifying standardised stress scenarios that will have a consistent impact across all banks. In general, the impact of any given set of market movements will depend crucially on the particular positions held in a bank's trading portfolio. In this regard, the Committee has carefully considered the trade-offs between standardisation of the stress scenarios that banks would be required to evaluate and the difficulties of permitting some degree of bank-specific analysis while ensuring a common degree of rigor. The Committee concludes that the best way to address these difficulties is to combine the use of supervisory stress scenarios with stress tests developed by individual banks to reflect their specific risk characteristics. Specifically, supervisors may ask banks to provide information on stress testing in three broad areas, which are discussed in turn below.

    (a) Supervisory scenarios requiring no simulations by the bank

5. Banks should have information on the largest losses experienced during the reporting period available for supervisory review. This loss information could be compared to the level of capital that results from a bank's internal measurement system. For example, it could provide supervisors with a picture of how many days of peak day losses would have been covered by a given value-at-risk estimate.

    (b) Scenarios requiring a simulation by the bank

6. Banks should subject their portfolios to a series of simulated stress scenarios and provide supervisors with the results. These scenarios could include testing the current portfolio against past periods of significant disturbance, for example the 1987 equity crash, the ERM crisis of 1993 or the fall in bond markets in the first quarter of 1994, incorporating both the large price movements and the sharp reduction in liquidity associated with these events. A second type of scenario would evaluate the sensitivity of the bank's market risk exposure to changes in the assumptions about volatilities and correlations. Applying this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of the bank's current positions against the extreme values of the historical range. Due consideration should be given to the sharp variation that at times has occurred in a matter of days in periods of significant market disturbance. The 1987 equity crash, the suspension of the ERM, or the fall in bond markets in the first quarter of 1994, for example, all involved correlations within risk factors approaching the extreme values of 1 or -1 for several days at the height of the disturbance.

    (c) Scenarios developed by the bank itself to capture the specific characteristics of its portfolio.

7. In addition to the scenarios prescribed by supervisors under (a) and (b) above, a bank should also develop its own stress tests which it identifies as most adverse based on the characteristics of its portfolio (e.g. problems in a key region of the world combined with a sharp move in oil prices). Banks should provide supervisors with a description of the methodology used to identify and carry out the scenarios, as well as with a description of the results derived from these scenarios.

8. Stress testing alone is of limited value unless the bank is ready to respond to its results. At a minimum, the results should be reviewed periodically by senior management and should be reflected in the policies and limits set by management and the board of directors. Moreover, if the testing reveals particular vulnerability to a given set of circumstances, the national supervisors would expect the bank to take prompt steps to manage those risks appropriately (e.g. by hedging against that outcome or reducing the size of its exposures).

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